By Paul Price
A life without mistakes is an impossible dream. Investing without disappointments along the way is equally unrealistic. With stocks and options bad choices typically result in losses. We like to think of Schedule-D write-offs as the tuition we pay for our stock market education program.
There is one technique that allows, what we hope are just occasional miscalculations, to be profitable ones. How can you be wrong yet still post a profits? Sell put options on stocks you think will go up.
Last January 29th I thought Quest Diagnostics (DGX) looked cheap at $58.25. The shares had touched $62 - $64 four times during the previous year. I expected that they would do so again before August 16, 2013. As of today DGX is still stick at $59.12.
Here is a customized chart I put together on Jan. 29, 2013 showing what those peak valuations looked like based on trailing 12-month P/Es at those moments in time. EPS for the four most recently reported quarters (through Sep. 30, 2012) were $4.50. At $58.25 Quest Diagnostics had a trailing P/E of around 12.9x.
DGX had other very favorable metrics beyond a modest multiple. The stock offered a good risk/reward proposition. Longer-term the looming implementation of Obamacare figured to stimulate demand for lab testing services. That remains true today.
Selling an August $60 put for $4.30 per share committed me to buying 100 shares at a net cost of $55.70. If DGX were to close at $60 or higher on expiration date the put would expire worthless and my obligation to buy would disappear forever.
DGX shares up slightly since January but have not sustained that $60 level as 2013 estimates were reduced from $4.46 to $4.33 per share. Here is how the stock has performed since I sold the August $60 put. The break-even (a.k.a. ‘if put’ price) of $55.70 is highlighted with the green doubled-headed arrow.
With one month to go before expiration the short put is in some danger of being exercised. ‘Rolling out’ the option will lock in a decent gain while reestablishing the same put position, but with a February 22, 2013 expiration date.
‘Rolling a put’ means ‘buying to close’ (BTC) the near-term short put while simultaneously ‘selling to open’ (STO) a longer term expiration put. In this case I’m using the same $60 strike price. I think DGX will ultimately go sustainably above that level.
Extending the expiration gives DGX more time to reach or exceed the needed threshold price.
Here were the actual closing quotes of the two options involved.
After the rollout my obligation to buy is still for 100 shares of DGX at $60. I have sold to open twice since starting the trade last January. I bought to close only once.
The first sale netted me $4.30 per share. The second sale brought in an additional $2.70 per share. I collected a total of $7.00 per share even from start to finish. My overall break-even point has been reduced to $53 /share.
By selling, rather than buying, the put option we can ultimately make more in the end by not succeeding on the first try.
See the full details of Market Shadow’s Virtual Put Writing Portfolio: http://marketshadows.com/virtual-portfolios/put-selling-virtual-portfolio/